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Lake Wobegon Meets Wall Street

Wall Street and the herd mentality.

In the fictional town of Lake Wobegon, "all the women are strong, all the men are good-looking, and all the children are above average."

In Wall Street's version, all stocks are strong, all industries will outperform, and all companies are above average.

That's what Catalpa Capital Advisors found when it sifted through analyst recommendations for each company in the S&P 500:

Source: Catalpa Capital Advisors. Chart re-created by author.

Catalpa elaborates: "The overall rankings show little variation over time. Currently, the median rank for all of the stocks in the S&P 500 is 3.9 [outperform]. Since 2008, the median has ranged between 3.7 and 4.0. Even in the wake of the 2008 financial crisis, analysts ranked most stocks now in the index above average and gave just three stocks a rating below 2 [underperform]."

How'd those recommendations work out? Catalpa did a regression analysis to see how rankings fared against subsequent stock returns. One year out, "consensus analyst ratings for the stocks in the S&P 500 have zero explanatory power." (r-squared of 0.004 for you math nerds).

Plenty of other evidence backs this up. One paper by Richard Taffler of the University of Edinburgh found that "new buy recommendations on average have no investment value with over half of such stocks earning negative returns over the following 12 months." The rare sell recommendation, on the other hand, does have predictive value. Another study found that, even when an analyst has a run of profitable picks, it's impossible to predict future prescience based on past performance. Hot streaks are usually just that: streaks.

What's going on here? The answer isn't as easy as just calling Wall Street an inept group of misguided seers.

Part of Wall Street's perma-bull stance has to do with conflicts of interests. Investment banks typically have several functions. One is raising capital for corporations; another is advising investors on the merit of those corporations. You can see how this relationship can get incestuous: If a bank badmouths a company with a sell recommendation, that company may take its business elsewhere when it needs to raise capital. Banks say they thwart this conflict of interest with a "Chinese wall" that separates bankers from analysts, but the walls aren't exactly impenetrable, to say the least.

Analysts may also give rosy recommendations to companies simply to gain access to its CEO. In a world where becoming a good analyst requires prying useful information out of executives, slapping a sell recommendation on a company's stock is a successful way of shooting yourself in the foot.

Just consider the story of David Maris. As Jesse Eisinger of ProPublica writes, Maris, a former Bank of America(NYSE: BAC) analyst, called out the shady dealings of drug company Biovail in 2003. In hindsight, Maris was exactly right: Biovail was, according to the Securities and Exchange Commission, engaging in accounting fraud. But his call was so controversial and damaging to Biovail that Maris "was sued, fired and stripped of compensation. He also lost access to the world of bulge-bracket Wall Street, was shunned by some institutional investors, and because of the settlement for which he said he felt he had no choice than to enter, he couldn't sue Biovail to seek vindication."

Analysts can also fall victim to cognitive biases. Stocks are supposed to go up, right? Isn't that the point? For mostly good reasons, optimism prevails in the stock market. Bearishness is usually contrarian, if not curmudgeonly. Analysts, not surprisingly, latch on to that optimism even when it flies in the face of their own analysis. One interesting study by a group from Purdue and the University of Texas found that the most bullish recommendations come when investor sentiment is highest, suggesting recommendations may have less to do with discounted cash flow than, say, the number of high-fives on CNBC.

What's this all mean for you? The most obvious takeaway is: Don't take Wall Street ratings too seriously. On the whole, they're about as convincing as Lake Wobegon.

A less obvious takeaway is appreciating the importance of underloved, underfollowed companies. The more analysts who cover a stock, the more recommendations it'll have. Since most of those are likely to be buy recommendations, the odds are that the more followed a company is, the more likely it is to be fully priced.

This doesn't mean you have to stick with obscure small caps no one's ever heard of. Several high-quality large caps like Altria(NYSE: MO), ExxonMobil(NYSE: XOM), 3M(NYSE: MMM), and Kimberly-Clark(NYSE: KMB) are followed by relatively few Wall Street analysts compared with wildly popular names like Apple and Google, which every aspiring analyst wants their hands on. The best returns don't necessarily come from great companies, but good companies that happen to be underfollowed.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.